Taking Risks and Reaping Rewards

Fannie and Freddie get folded into the government. It’s about time.

On August 25, 2003, I posted a comment on F&F being in trouble and that the housing bubble could burst and create a huge problem for the economy. In 2003! Why? How did I know such a thing could happen over five years ago? Because of the misalignment of incentives due to the implied government backing of F&F. It was obvious before five years ago, but that's beside the point. It took awhile, but now it's finally been resolved. It's about time.

A firm is either public or private and when they try to be both at the same time, it's a problem. The current situation is case in point. F&F had the implied support of the federal government so those that ran the organization acted differently than they would of if they didn't have that support. Investors also made decisions about the firm securities based on this. The incentives to maximize personal gain can't be dismissed and when the check and balance that the market imposes gets removed, things go awry. In other words, Adam Smith's invisible hand will make an obscene gesture if messed with.

Free markets, by and large, provide reward commensurate with risk taken. When that is breached, there is a misalignment of incentives and that causes problems, some of which, like this one, are significant. Alignment of incentives, leaving the risk stay with those that might profit, is a small, but significant, difference and all that it takes to misguide an organization and lead it toward where F&F are now.

F&F were able to securitize and sell their loans to the market, basically selling debt, long beyond what they should have been if there was no implied government backing. The market simply wouldn't buy them as they were too risky. But with the implied backing of the federal government, investors and financial firms continued to buy their debt which allowed them to keep the upward spiral going (The spiral is F&F buy loans, securitize, resell, take that money and buy more). Everything is fine as long as the spiral keeps going up. But it can't go up forever.

The typical market mechanism of price to resell the securitized loans would have been what stopped the upward spiral for a typical private firm. Bu it didn't work due to the government backing. In other words, the risk of default was seen as basically risk free as the government has to pay the debt or the entire system will collapse. That being the case, the return isn't commensurate with the risk, it's much higher. It's like buying a treasure bond that pays several points more than the going rate. Typically, the market runs in cycles with an upward spiral, commonly called a boom, that leads to a cliff, commonly called the bust. If markets are functioning properly, these cycles are pretty small. But when the pricing of risk is removed, the incentives to profit are too great to ignore and the size of the boom and, therefore the bust, can grow to catastrophic size.

It's the size of the two firms that mandates the government involvement. They are so large that if they were allowed to fail the entire financial system would collapse. As we can't let that happen, we have no choice but to do what is being done and make debt holders secure. So the taxpayer is going to cover the big bets by China, Japan, and others, that we would bail out the debt holders to save our own skin. Good bet that.

On Oct 5, 2006, I posted a comment saying that, "How many things are out there that the government, essentially the tax payers, are going to have to cover in the event of a disaster? Fannie and Freddie are but two." As we look forward, the details of the next problem that will be covered by the taxpayer aren't clear. Look for misalignments of incentives and rewards that compensate greater than the risk taken. While you're doing that, get out your checkbook. This one is going to sting a bit.